Central banking in crisis

The appointments of central bank governors have become almost as high-profile and important as that of finance ministers. In recent weeks, UK, India, and shortly the US, would have nominated new central bank governors. Many expectations have been raised about their ability to pull their respective economies out of their current economic weakness. But this apparent success may carry certain under-appreciated risks.

The original mandates of central banks have been to maintain price stability and in some cases promote sustainable growth. In India, apart from being the banking sector regulator, the Reserve Bank of India (RBI) is vested with the mandate of “securing monetary stability”. Accordingly, the primary task of the central bank has been the stabilisation of inflation, through policy instruments that influence the interest rate.

The global financial crisis and the Great Recession that followed have dramatically changed their mandates. It has pitchforked central banks to the epicentre of national economic policy making. In fact, they have become the single most important actor, eclipsing even governments. Their actions have generated much discussion and have influenced the markets more than any action of the government.

Governments should take the blame for this turn of events. Fiscal constraints, political paralysis and sheer ineptitude have all contributed to governments, in many developed and developing countries, becoming marginal players, sometimes even going missing in action as their economies tanked. They have preferred to watch and goad central banks into aggressively pushing their operational boundaries in the misplaced belief that it entailed limited costs and it could be a substitute for their own inaction.

Accordingly, central banks have pursued policies which have blurred the lines between monetary, credit, and fiscal policies. Truth to tell, in most cases, they have done a creditable job with their expanded mandates. The RBI too has not bucked the trend. Its actions have assumed prominence because of being forced into leading the fight initially against a persistent high inflation and now a falling rupee.

The Indian economy today faces adverse headwinds in many fronts – unsustainable fiscal and current account deficits, persistent high inflation, supply constraints, and declining growth. All these feed a self-fulfilling downward spiral of negative sentiments. Multiple policy distortions and failures, which have less to do with the RBI’s actions, are the major cause for the current crisis.

Critical structural reforms and policy shifts, with medium to long time horizons, are necessary to overcome these problems. Apart from helping the government minimise damage from the immediate crisis, the RBI can only facilitate the required reforms by working to provide monetary stability. The government has to bite the bullet with reforms.

But such has been the dominant role of the RBI, as well as the government’s self-imposed marginalisation, that we have come to expect more from Mint Street. It merely reflects a cognitively biased over-estimation of the Central Bank’s capabilities and powers as well as a similar overlooking of the government’s responsibilities. Most unfortunately, such perceptions end up blaming the RBI for the government’s failures, especially when things do not improve quickly, as they are likely to given the magnitude of our problems.

Consider two recent instances of criticism of the central bank. First, in order to tame persistent high inflation, RBI continuously tightened monetary policy since early 2010, even in the face of a rapidly slowing economy. Second, more recently in July, in order to support the rupee the RBI tightened further by steeply raising the rates on other policy instruments.

On both occasions, the RBI was only trying to manage a crisis that arose from multiple policy failures and whose inevitable result was growth contraction. However, given the perception of its dominant role in addressing broader macroeconomic problems, it was accused of constraining growth. Ironically, even the government thought so. In both cases, irrespective of the party in power, it would have been tempting for a finance minister to mount pressure on the RBI to reverse the course. Supporters, including a large section of the opinion makers and corporate India, would have acquiesced with such actions.

This also highlights the importance of the political economy in monetary policy decisions. In an ideal world, it can be reasoned that a central bank should stay the course with its policy actions. But in a real world, central bank agents have to pay heed to their government principals. In fact, it is well known that central banks do not take interest rate decisions based on a highly technical and formulaic objective function. Their objective function is more heuristically determined by both economic and political considerations. It is therefore not surprising that Chairman Bernanke did not embrace the full prescriptions of Professor Bernanke. Nor did Dr Subba Rao go the full distance with tightening on the face of a persistent inflation.

If the RBI remains too insulated from the political economy, then it is only a matter of time before politicians assume control. The recent example of Japan, where the Bank of Japan refused to deviate from a very rigid inflation targeting regime even in the face of a long deflationary recession, is a case in point. It finally led to the new Prime Minister Shinzo Abe virtually taking over and dictating the central bank’s agenda.

All this may be more relevant to countries like India where the institutional credibility of the central bank is fledgling. In a country where governments have constantly chipped away the credibility of all important public institutions, it may be too much to expect the RBI to escape the trend, especially if its operational domain expands and its actions become divorced from important political economy considerations.

The institutional credibility of the RBI lies in the perception of its competence and independence. This can be achieved only if the government steps up to assume its central role and the RBI restrains from over-expanding its operational domain either on its own or in response to government pressure. Opinion makers can help this by a better appreciation of some of the aforementioned dynamics that govern monetary policy making.